I am learning about Options, f
I am learning about Options, futures and hedges in my upperdivision finance class and I am struggling to figure out a part ofoptions. What stops someone from from buying a call option at alower price and turning it around and selling it at at higher pricefor profit?
what I mean by this is for example, the current price of a stockis $100/share and you enter a call option contract on 1/1/18 with astrike price of $150/share with a premium of $5/share. the expiryis on 4/16/18. on 4/16/18, the current market price for the stockis $200/share
what stops someone from entering that contract, then on theexpiry date, buying and then turn around and selling it right awayat the $200 market price, gaining a $45/share profit after takingout the premium? Is there some type of law stating you have to holdonto those shares for a certain amount of time? Or am I completelymisunderstanding the concept all together? Because if that IS howit works, then it would essentially be risk-free trading right?besides losing the premium on a bad call and letting it expire,youre guaranteed to make money if you take advantage of the callprice.
When I asked my professor, he didnt answer it, rather he workedaround the question and all I got out of it was time value ofmoney, which is a concept I have learned in the past but have yetto go over in this class
Answer:
Sorry, but You have misunderstood some concepts. Yes! It istrue, this concept belongs to “Time value of money” in derivativescontext. Let me explain you each and every step-
Options- Are the financial contracts that are bought by oneparty and sold by another party. Options are derivatives contractthat are traded on exchange. These are mainly of two types-
Call- Call is a right but not the obligation to buy a certainasset at a specific price. We buy call when we are bullish towardsthe secutity or overall market so when sock market or thatparticular security go up, call increase and gives profit.
Put- It is a right but not the obligation to sell a certainasset. We buy put when we are bearish towards a particular securityor stock market so when the market comes down, Put increases andgives us profit.
Premium of Options- Premium is nothing but the price of anoption that is getting traded on the exchange. When we buy options,we have to pay the premium.
Your Question: What stops someone from entering that contract,then on the expiry date?
Options have their expiry date. If you buy the options on thefirst date or any date of the month before expiry, you have tosettle your position by selling it or letting it go (If OTMoptions) anytime on or before expiry.
Option are of three types; In the money, At the money and Out ofthe money.
ITM- When spot prices is greater than Strike price.
ATM- When spot price is equal to strike price.
OTM- When spot price is lower than strike price.
As far as time value of money concept concerned, options havetheir time value. As the time passes and expiry date comes nearer,options lose their values, their value(premium) decreases as theexpiry date comes closer. So an option is trading at $5 on 1/1/18,will come down to $1 or so on the expiry day. Options lose value oftheir premium as the expiry comes closer irrespective of the spotprice. If spot price is slight high then also options will not havethe same value like they had when the month started.
Maximum Loss- Some traders say that options are riskier product,it is true to some extent but if you buy options (Call/Put), yourloss will be limited to the extent of premium, you pay to buy anoptions contract as you know the downside and profit will beunlimited. In the worst case scenario, options’ premium will bezero (0). On the other hand, If you sell/write the options, yourloss will be unlimited as you do not know the upside but yourprofit will be limited to the premium, you get while writing theoptions.
Your Ques: What stops someone from entering that contract, thenon the expiry date, buying and then turn around and selling itright away at the $200 market price, gaining a $45/share profitafter taking out the premium? Is there some type of law stating youhave to hold onto those shares for a certain amount of time?
Options are different from shares, Shares work as underlying foroptions. Traders do not buy options on expiry date because onexpiry date, futures and options are settled and old contracts getexpired and new contracts start from the exact next day of expiry,OTM options become zero on the expiry date while ITM options havesome value.
Your Ques: It would essentially be risk-free trading right?
No, It is not fully risk free trading. You know your maximumloss/risk that is limited to the premium you pay (Buyingoptions)
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